Seafarer Portfolio Review 3Q2017 – Decoupling

Decoupling Definition – Generally speaking, decoupling is the divergence of two asset classes from their expected or historical pattern of correlation. For example, if emerging equity markets historically tended to rise and fall with a high level of correlation to U.S. equity markets, decoupling would imply that going forward emerging equity markets would rise and fall with lower correlation than history would imply.

Andrew Foster, Chief Investment Officer and Portfolio Manager of Seafarer Overseas Growth & Income Fund, highlights in his most recent portfolio commentary why he believes decoupling may be real this time. He views decoupling as the potential for emerging market assets to offer diversification benefits (lower correlation relative to U.S. assets) to portfolios over a complete market cycle.

Foster points to three main reasons that decoupling may be real this time (as opposed to when the term was trumpeted over a decade ago, when he was not a “fan” of the term).

Increased evidence that emerging market central banks have more freedom to set their own monetary policy. Historically, emerging market central banks have been tied to movements by the U.S. Federal Reserve. However, emerging market local bond markets have attracted significant capital, which has resulted in less dependence on borrowing in U.S. dollars. One result has been a divergence in interest rate cycles.

Most currencies, with a notable exception being China, are managed to allow their currency exchange rates to “float” relative to the U.S. dollar. Foster believes that the constant fluctuation in currency values reduces the chance that large imbalances could build to the point of triggering a currency collapse and associated contagion that would result in defaults.

Emerging markets enjoy greater profit independence than in the past. Seafarer’s analysis suggests that emerging markets’ dependency on trade with developed markets began to decline in 2005. Today, emerging market domestic economic growth is higher than export growth. So, while still important, trade with developed markets is not as important to overall economic growth as it once was. In addition, corporate profit growth is not highly correlated with domestic economic growth or trade growth. In turn, he believes that emerging market profit cycles will be increasingly independent of global trade cycles.

In summary, he believes the theory of decoupling has now become more credible than a decade ago because emerging markets enjoy a higher degree of interest rate independence, currency independence and increased corporate profit cycle independence.

Our Take

Seafarer is one of many asset managers whose materials we read on a regular basis. We view its work in emerging markets as particularly useful during our market and economic reviews.

We strongly agree with Andrew Foster and the team at Seafarer regarding the potential benefit to portfolios over the intermediate-term from emerging market decoupling.

The combination of positive factors noted in Seafarer’s commentary, along with other factors noted in the research focus of our third quarter commentary, make emerging markets one of the areas of emphasis in our portfolios currently.